Analysis: Foreign tax credits, low margins and a globalized business have some wondering if the visual-effects business can continue to survive

Within 24 hours, Rhythm & Hues Studios went from accepting a BAFTA award for its arresting visual-effects work on "Life of Pi" to filing for Chapter 11 protection.

It was a shocking turn of events for a company that is up for two Oscars for its work on the 3D epic "Pi" and for "Snow White & the Huntsman," and a sign that the visual-effects industry may be headed for a reckoning.

Just last week, it seemed Rhythm & Hues had cooked up a deal to avoid bankruptcy thanks to a $20 million loan from three studios designed to keep it afloat until it could be purchased by Prime Focus, a visual-effects company based in India.

But the deal with Prime Focus fell apart, and Rhythm & Hues acknowledged publicly Monday that it has been forced into reorganization. The company still has buyers circling, and Prime Focus remains interested in a deal or partnership if Rhythm & Hues emerges from Chapter 11, individuals with knowledge of the situation told TheWrap.

"File this under the headline of 'it's a tough business,'" Eric Roth, executive director of the professional organization, the Visual Effects Society, told TheWrap. "If there's a moved start date or a tax incentive didn't come through, that can put a company in serious jeopardy. When you look at what's happened over the last few years — the globalization of the industry, the globalization of the world economy and the worldwide recession — it's not a new story, but unfortunately it's a terribly real one."

At the movies, special-effects sell, with elaborate digitally-enhanced spectacles like "The Hobbit: An Unexpected Journey" and "The Hunger Games" helping the business shatter box office records last year.

Yet instead of reaping a financial windfall,the visual-effects companies responsible for some of the most eye-popping film fantasies are struggling to survive. The possible bankruptcy of Rhythm & Hues and reports that DreamWorks Animation is poised to lay off as much as 25 percent of its work force have sent a chill through an industry that has already been hit hard by diminishing profit margins and an arms race to underbid the competition.

In the case of Rhythm & Hues, canceled and delayed projects left the company on the brink of ruin, while DreamWorks Animation is reported to be cutting back after losing money on "Rise of the Guardians" and rearranging its production schedule. Because projects frequently go to the lowest bidder and big budget productions are susceptible to shifts in release schedules or delays, larger effects houses like Rhythm & Hues feel tremendous financial pressures when plans go awry.

"If you have several hundred people sitting around with nothing to do, it's very costly," said Steve O'Brien, CEO of Reel FX, which does animation and effects work for feature films and commercials. "Two months of nothing to do eats away at the net profit from the job you just did."

As the demand for these effects have grown so has the competition and the price of doing business. Moreover, tax incentives doled out from London to Louisiana have forced companies to establish a wider global footprint, contributing to rising overhead and staffing costs.

Regardless of what events set off the latest tremors, pink slips and fire sales have become all too common, visual-effects industry executives and designers say.

In recent years, Asylum Visual Effects, CafeFX and Illusion Effects are among the roughly half-dozen visual-effects companies forced to shut their doors. Others have bowed to financial pressures and put themselves up for sale, such as Digital Domain, which filed for bankruptcy and was acquired by Galloping Horse America and Reliance Mediaworks for $30.2 million last September.

Many of the California-based visual-effects companies that remain, such as Disney's Industrial Light & Magic or Sony Pictures ImageWorks, are aligned with a major studio, allowing them to better withstand any fluctuations in the market for effects work.

"I have this sunken gross feeling in my stomach, [Rhythm & Hues] is legendary," said Payam Shohadai, co-founder of Luma Pictures, an 100-person visual-effects shop that has worked on "Prometheus" and "The Avengers." "It's startling and painful to see companies that are more experienced and more institutionalized struggle like this."

On Monday, some members of Rhythm & Hues' 1,400-person staff were told their services would no longer be needed. The rest of the employees will continue working on various projects that were lined up before the company suffered its downward turn, Rhythm & Hues said while trying to sound a hopeful note about its future.

"Following the filing, R+H will be seeking to secure financing for future growth," Lee Berger, president of Rhythm & Hues Film Division, said in a statement. "I believe that we are going to come out of this situation stronger, more efficient, and as prolific as we are now.”

The employees who have been let go will enter a business environment that offers less and less job security for the designers and artists who labor on big-budget productions. Now, effects workers hoping to move up the ladder have to be willing to uproot their families to move from one country to another as the business becomes more global and less California-centric.

Some visual-effects industry executives and artists blame studios' hunger for tax incentives for fostering an environment where foreign and state governments are constantly undercutting each other with ever more generous film production credit packages. That in turn, has lured many major projects out of Los Angeles to places like Canada and the United Kingdom, forcing visual-effects shops to open up far-flung outposts to stay competitive.

"If we didn't have an office in Canada, we'd be out of business," a visual-effects executive told TheWrap. "Los Angeles is a ghost town for visual effects. So few movie shoot in town anymore and studios would rather give work to a foreign company and get a credit — even if the finished product is lower quality."

One visual-effects worker launched an insider blog to anonymously document and comment on the upheaval in the industry. Under the pseudonym VFX Soldier, the worker decries the system of subsidies, claiming that they violate international trade agreements by distorting the price of effects work.

VFX Soldier is moving beyond rhetoric and mounting a legal challenge to foreign film credits. It is getting readers in on the action by soliciting donations to fund the effort. Last December, the blog raised $13,000 from more than 180 donors, which it used to hire an international law firm to conduct a feasibility study. VFX Soldier said the goal is to determine the best legal avenues for taking on these major media conglomerates.

"It's a long shot," the writer of VFX Soldier told TheWrap. "But my ability to get into this industry was a long shot. No matter how good or efficient you are as a company right now, you're at the mercy of the next government that comes in and undercuts the process by offering more money. So you'll keep having jobs go to India, China or whatever the next place will be."

California has tried to compete with other states and foreign governments by offering its own $100 million in tax credits annually. However, that pales next to states like New York, which offers $420 million a year in production-tax breaks.

Boosters of tax subsidies argue that filmmakers have a responsibility to do everything they can to lower costs and incentives have become a crucial part of financing production.

"Motion picture and television companies are a business like any other," said Vans Stevenson, senior vice president of state government affairs at the Motion Picture Association of America, the industry's lobbying arm. "We’re in a competitive worldwide economy, and it would be irresponsible for a company to not manage production costs as effectively as possible."

Yet Rhythm & Hues, like Digital Domain before it, aggressively chased subsidies, opening up branches in Canada, for instance. It also moved into places like India and Malaysia with the goal of lowering labor costs. It understood the economic realities of the business, while continuing to do award-winning work, and it still struggled financially.

Regardless of whether or not the hunt for tax credits bear any culpability for Rhythm & Hues' financial woes, visual-effects veterans say too many companies are balanced on a knife-point. Too many players are one canceled project away from missing payroll.

"Rhythm & Hues was a company that was pretty well run, that treated its employees well, that understood the global marketplace, that took advantage of tax incentives and still encountered problems," Roth said. "When a company this prominent has something like this happen, you're seeing the results of a business that really needs to find fresh ways to modernize."